On bank fees and the future of banking
My A-level Business Studies textbook had a diagram on the flow of an economy bank was the centrepiece of the diagram. It was drawn in a way that anyone who looks at it would realise that, without a bank, the entire economy would collapse. Naturally, I got curious about how this seemingly very important institution called ‘bank’ is making money. Through some readings and questioning, I learned that their main source of revenue was to borrow cheaply from other institutions, consumer deposits, central banks…etc and to lend the money at a higher rate. I also learned that a sizeable portion of their revenue was from ‘fees’ such as a transaction fee or ATM withdrawal fee (rare nowadays). Interestingly, the percentage of interest margin and amount/percentage of fees that they were charging seemed so minuscule and I never bothered to question it. That changed as I started working at a bank.
This essay is on the learning I made on bank fees and why I came to believe that everyone should question the fees they are paying in order to protect their wealth and make the best use of banking as a service. I would also disclose that in this essay, fees have a broader definition than FDIC’s definition of deposit account fee and applies to all money that consumers (not institution customers) pay in exchange of a service.
First, let’s get a rough idea of how much banks are making in fees. Table 1 below shows how some of the largest bank’s revenue is broken into its source and business segment.
As we can see from Table 1, about ~50% of banks revenue comes from collecting fees of some sort and a large part of it is carried out by their consumer-facing business segments such as Consumer/Retail banking and Asset/Wealth Management. A remaining big chunk of fees are collected by other segments but we will exclude them because those segments mainly deal with institutional clients (i.e. such as a company doing IPO with Investment Banking). So as you can see from this, we as an individual client collectively pay a substantial amount in fees in exchange for the banking/financial service we receive. But what are we really getting from these fees and how do banks justify sucking billions of dollars out of our pockets every year? The two largest reasons that the banks claim to charge the fees are 1) to support operational capabilities and 2) financial advice. Let’s dive deeper into each and understand to what extent the reasons can be justified.
Fees to support operations
Fees collected for this reason is easier to justify because the benefit to us is tangible. Bank branches are located close to a most residential area, ATM machines are available 24/7 and we are able to pay our bills, send/receive money without worrying about theft. As can be seen from Table 2 the consumer-facing segments spent around 50% of their non-interest expense on this category to which most of us would not have a much objection to.
Although, as I will be touching it later in this essay, the merit of having tangible service available is quickly diminishing because of online banking and I foresee that banks will increasingly have a hard time justifying their fees collected for this reason. Its like trying to maintain your cottage even though you visit only once a year!
Fees for financial advice
I have bigger trouble with this reasoning for fees charged on financial advice and for selling investment products (sometimes called commissions). The reason I have trouble agreeing with this fee is that they are 1) misrepresented and/or hidden, 2) performance-related fee is asymmetrical, 3) fixed fees are misrepresented, and 4) outright scam fees (outrageous fees).
It is also worth noting that the reasons I provided are most prevalent in customer segments where individual account size is between $300k ~ $5m (emerging wealth to lower end of HNW) because the AUM per account is large enough and the customers start developing interests to participate in financial markets through sophisticated (obscure really) financial products. This, in my opinion, provides banks with the perfect venue to oversell and to churn client accounts.
Misrepresentation and hidden fees
You would think that the banks are disclosing all fees related to the services and products that you are receiving/purchasing. In most cases this is true. For instance, the brokerage fee for trading stocks, and front-end/back-end load fee for subscribing into Mutual Funds are examples of fees you pay directly and disclosed to you. As you get into more sophisticated financial services, however, things become greyer. For example, derivative related note products such as Structured Products that banks recommend to their clients for a potential to earn higher interest rate than deposit rate through earning option premiums on underlying assets are typically settled in 14 days. This means that from an ‘ issue date’, which is the date that you agreed to invest, your money isn’t put to work for 14 days and is earmarked in your cash account until the settlement date or the date when the money is transferred to the banks that issued the note (typically an Investment Bank). The problem with this is that the yield that was presented to you is typically calculated from the settlement date and maturity date and not between the issue date and the maturity date. In the end, the potential return percentage is given an of 14 days which artificial exaggerates the yield. You might think 14 days is not big of a deal but this ‘hidden fee’ is on top of the typical 2.5% commission (disclosed to you) that you pay to your bank, which is another misrepresentation at work. You see, when the bank quotes you a commission of 2.5%, what they mean is that they are purchasing the note from an issuer at $97.5 and selling it to you at $100. Since their cost is $97.5 and their earning is $2.5, the correct math should be $2.5/$97.5=2.564%. You might say this is a negligible amount but these banks sell billions of these notes and the difference of this ‘negligible’ 0.064% amounts to $6.4m extra accounting revenue per every $1B sold.
Another hidden fee is layered fees or fees paid by the bank to the issuer, similar to a wholesale and a retail concept in other industries. Let’s take the structured product from the previous example. When the bank is quoted $97.5 price from the issuer, what this means is that it is even cheaper for the issuer to issue this note (since the issuer needs to make money too). The issuers typically charge 0.5%~1% which means they ‘wholesale’ price was ~$96.5. So essentially, you paid $100 for something that cost ~$96.5 to make but this is never disclosed to the clients.
Before moving to the next, I want to bring up that such misrepresentation isn’t alone to the financial industry. For example, golf club manufacturers always bring out new drivers almost annually that promises to give 5~10 yards more distance than their previous model. The reality is I am still hitting ~240 yards and if the manufacturers’ claims were true, my drive distance should have double in the past 10 years. It has not. So when you are being sold something, always remember to put on your sceptic’s glasses and ask questions. I wrote about this in another essay ‘second-level thinking’ as well.
Skewed performance fee
Another trouble I have with this fee category is that the risk and reward is asymmetrical for the bank but symmetrical for the clients. In other words, the client is fully exposed to the downside risk of a financial product/advice received while the banks share 0% of the downside and sometimes claims some of the upsides. This sharing of the upside is partly mitigated by clauses such as high watermark and claw-back, but the fact that they still share 0% of downside remain unchanged.
Fixed management fee
A fixed management fee of ~1% is not uncommon and seem to be the industry standard that both the financial institution and customers have come to accept. After all, 1% doesn’t seem that much but I want to dissect this and make a point that it is in fact a substantial amount to pay.
Let’s say you have $1M in a financial institution and they charge an annual management fee of 1%. Let’s also assume that the institution generates 6% return on a portfolio that they constructed with your $1M. In effect, you have earned $60k return and paid $10k fixed fee. But for what purpose are you paying this money? Obviously, it is not to safe keep the money because you can do this with no fee at a cash deposit account. Also, you are not paying for the first ~2% of the performance because you can safely generate this return without any professional advice (i.e. buying a government bond or a long term fixed deposit). In effect, you are paying this money to generate the extra 4% (or $40k) return so a more accurate way to calculate the fee is $10k/$40k or 25%.
Outrageous fees
Below is list of some fees I have come across which I find it a borderline scam.
- A fee charged for coupon payments on bonds
- Safekeeping fee (literally for holding onto your money)
- Hold mail pickup fee
- Courier fee for sending documents to you
- Fee for producing a letter that proves the balance of your account
- Fee for producing a valuation report
These aren’t charged by small banks trying to survive but by large banks, usually associating the fees as a necessary step to engage with their prestigious name.
Future of banking
Banks, as we know, will stay for longer than many people speculate because there will always be a large part of the population, such as boomer generation, that will refuse to go online for reasons such as feeling insecurity and unfamiliarity. However, a growing portion of the younger generation will slowly switch to online banking and a few of the Fintech companies in this area will be a dominant player in the near future (my take on this here). Key is to continue finding creative ways to reduce fees (so far it has mainly been on ‘no branches’ feature) such as incorporating DeFi while enhancing convenience and accessibility. It is also vital that these companies to grow a strong identity, differentiated from the traditional banks because the banks are also heavily investing in a cheaper and more convenient online banking experience (such as DBS from Singapore). *I wrote more about this here.
Just as many new entrants are overtaking incumbent giants (for example, Tesla over Ford/GM, Airbnb over Hilton/Marriott and Apple over Nokia…etc) I hope to see some of the growing Fintech companies overtake the conventional giant names such as JP Morgan, Citi, RBC…etc
*I came across another hidden fee, a net interest margin. Patrick McKenzie wrote an essay about how brokerages make money and briefly mentions how the net interest margin is ‘the cost that does not call itself a cost.’ You can read more about it here.
